Post GFC, there is a renewed awareness of the volatility of markets and the need to diversify investments to hedge against it.
Portfolios should not be 100 per cent invested in a single asset class let alone a single venture. The only exception would be a 100 per cent cash allocation to government guaranteed term deposits. But a “no risk” strategy has it’s own problems and in this environment it means low returns and the strategy, while safe, may not deliver enough income to live. Finding a balance is important.
Bonds are a great diversifier and can help protect your wealth and income throughout various economic cycles while providing better returns than term deposits. If you are new to bond investment, here are some questions that may help you determine how much of your portfolio you should allocate to defensive assets.
- How much income do you need to maintain your lifestyle? Investing in securities that have a known income will help achieve these goals.
- How much capital do you need to maintain your lifestyle? Many investors have aspirations to leave a specific amount to children and grandchildren; how do you make sure those funds are preserved?
- How old are you? The older you are the less time you have to recover lost capital. Also as you age, your earning potential may decline, again you may not be able to work to recover any losses. Investors should consider that they generally need to be more protective of capital as they age and if you don’t have enough capital to support your lifestyle when you retire, then it’s not a good time to invest a high proportion in high risk assets.
- Do you have any known future expenses? If you know you need funds for an event like a wedding or holiday, these funds should be set aside. Bonds can be acquired with cash flows and maturity dates to suit known future expenses.
- What is your risk appetite or maybe more appropriately, how much are you willing to lose?
- Do you have the capacity to earn income to supplement losses? If you still work, even on a part-time basis, that income will help protect your lifestyle and allow you to take additional risks.
- Is your portfolio diversified so that the investments you hold are across different industrial sectors, have varying maturities and risk profiles? Diversification is key to running a successful SMSF. To achieve a diversified fixed income portfolio you should hold different types of bonds, such as fixed and floating rate notes, inflation linked and government bonds. A portfolio with a 100 per cent allocation to shares is not diversified, in the GFC, the value of practically all shares declined.
- How liquid is your portfolio? If you need to access a large sum quickly, can you do so without losing value on the investment?
- What return do you aim to achieve? This is often the first consideration of investors and while important should be considered in light of the above. Remember higher returns often mean higher risk.
By considering these factors and discussing them with others in your SMSF or your financial advisor, you’ll be better prepared when making decisions about which investments to include in your portfolio.
This article also appeared in The Australian.
